Canada: How Snowbirds Can Avoid U.S. Estate-Tax Traps

Previously published in The Fund Library 

Snowbirds who decide to buy U.S. real estate may run into a host of cross-border tax traps, problems, and pitfalls. (See my previous article on these.) And if you were hoping to pass along that little piece of paradise to your heirs without a visit from the IRS, forget it. If you continue to own the U.S. property until you pass away, you will be subject to U.S. estate tax, which in the past has ranged from 18% to as high as 55%. Luckily there are a few strategies to help you reduce or eliminate the U.S. estate tax bite.

Currently, the U.S. estate tax rate ranges from 18% (where value is less than US$10,000) up to 40% (on amounts exceeding US$1 million) on the fair market value of your U.S. property.

Prorated exemption is available

Fortunately, there is currently a US$5.34 million exemption available for U.S. estate tax for U.S. residents/citizens. And under the Canada-U.S. Tax Treaty, Canadians are allowed similar treatment, although you must prorate the value of your U.S. property against the value of your worldwide estate.

Essentially, Canadians are able to take advantage of a unified credit, which can reduce or even completely shelter the U.S. estate tax payable. In 2014, for U.S. residents, this credit is calculated as the tax payable at a 40% rate on US$5.34 million (US$5.43 million in 2015) of assets, or about US$2.08 million (US$2.12 million in 2015). For Canadians, the exemption is prorated based on the ratio of their U.S. assets compared with their assets as a whole.

While tax relief provided under the Treaty may reduce or eliminate the IRS tax take, there may still be instances where Canadians are left with a U.S. tax liability. In this case, estate tax that's paid may be eligible as a credit to offset Canadian income tax on U.S. income. The Treaty also provides for a marital credit where property is left to a surviving spouse.

The calculations can get complicated, so some expert tax help is definitely recommended.

Avoiding U.S. estate tax has become a highly discussed topic in Canada over the years. The CRA's announcement in 2004 clamping down on so-called "single purpose" corporations meant that U.S. estate-tax avoidance strategies have had to be rethought.

For example, the use of nonrecourse debt may reduce the value of the property for estate tax purposes in the U.S. since the lender's only recourse is to foreclose on the property.

So if a non-recourse debt is outstanding at the time of death, the debt may reduce the value of the property, dollar for dollar, thereby reducing the value of the property for U.S. estate tax purposes. Accordingly, one may want to consider speaking to your financial institution about putting a non-recourse debt in place.

The trust option

An alternative option could also involve holding the U.S. property through a trust. This has become a more popular alternative. A Canadian resident trust would be formed and structured in such a way that while the U.S. property is in the trust, no U.S. estate tax is payable.

The downside, however, is that since a Canadian resident trust is deemed to sell all of its assets on every 21st anniversary of the trust, there could be a Canadian capital gain tax hit if the property has grown in value.

Accordingly, for Canadian purposes, it is important that the property be distributed out of the trust before its 21st anniversary. The use of a trust really only defers U.S. estate tax to future generations who are beneficiaries of the trust. Note – even though the trust would be a Canadian trust, you should obtain U.S. tax advice to ensure it contains the proper drafting to avoid U.S. estate tax during the lifetime of the trust.

On a happy note, if the U.S. property is a true rental investment (and not a personal-use property), ownership of the property in a Canadian holding company may still be an option – but if the property is personal use, then this option could result in Canadian tax to you.

Getting advice

As you can see, cross-border tax issues for Snowbirds who own U.S. property can quickly become incredibly complicated. So even though it might never occur to you to talk to your tax advisor when buying a U.S. home, doing so could help you properly structure the ownership of a U.S. property and avoid, or at least defer, U.S. estate tax.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.